Great Depression

Great Depression is unique in US economic history – Severity and the length – It takes a decade for per capita gdp to exceed 1929 level

yearReal gdpGdp deflatorReal gdp per capita 1929$ $8, $ $7, $ $6, $ $5, $ $5, $ $6, $ $6, $ $7, $1, $7, $ $7, $1, $8, $1, $8,832

Events of the Great Depression NBER dates beginning in August 1929 Stock Market Crash October 1929 From August to Oct, industrial production fell from 114 (1935–39 = 100) to 110 for a decline of 3.5 percent (annualized percentage decline = 14.7 percent) Continued to fall to 100 Fell an additional 21 % in 1930

Events of Great Depression Recession of was not unusual by historical standards Banking panics and failures started in Oct 1930 and continued to Dec 1930 – Harvest failure in midwest 2 nd Wave June 1931-December 1931 – Bank failure in Europe, Britain goes off gold standard

3 rd Wave- December 1932 –March 1933 Result is decrease in money supply and faith in banking system Unemployment is 25 % by March 1933

Cause of Bank Failures? Before Fed, banks would suspend payments, clearing house banks would lend money to failing banks Fed was suppose to do this but did not Argument made was speculative ventures should not be bailed out

Treasury Secretary Andrew Mellon, advised President Hoover to “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people”

This did not happen. Economy did not rebound. Causes of Great Depression – Monetary explanation – Non-Monetary – Gold standard

Monetary Explanations Friedman and Schwartz Fed does not step in as “Lender as Last Resort” in Banking Panics causes huge decrease in Ms – Banks hold more reserves – People put less money in banks Each banking panic makes this worse

Quantity Theory of Money Monetary theory tells us what effect changes in money supply have an economy The basis of the quantity theory is the equation of exchange: MV=PY

Quantity Theory of Money M=money supply V=velocity – Velocity is how often money is turned over or used P=price level Y= real income

Quantity Theory If we assume just V is constant or stable, The equation of exchange (MV=PY) that if M increases, PY (nominal income )will increase. If deflation is anticipated, when M falls, P will fall If deflation is not anticipated Y will also fall – In this case money supply is not falling because of direct action by fed, panics difficult to anticipate

Nominal vs Real interest rates Fisher equation R= r+∆P/P or r=R- ∆P/P In deflation real rate is higher than the nominal rate Nominal interest rates are low, but the real rates were high

Fed did not understand this, did not attempt to lower real rates Result was reduction in output – Reduced investment – Opportunity cost of holding money is negative

Criticism of Monetary Hypothesis Not clear Fed’s understanding of Monetary policy was great enough to act in the was FS said they should Not clear if it can explain long term

Non-Monetary Views Most can be explained in context of simple AD AS model

The Long-Run and Short Run Equilibrium Natural rate of output Quantity of Output Price Level 0 Short-run aggregate supply Long-run aggregate supply Aggregate demand A Equilibrium price Copyright © 2004 South-Western

Shifts in AD The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX Consumption – Expected future income or wealth, taxes Investment – Investors confidences, taxes, lower interest rates Government Purchases – Government decides to spend more or less Net Exports – Recession abroad

A Fall in Aggregate Demand in LR and SR Quantity of Output Price Level 0 Short-run aggregate supply,AS Long-run aggregate supply Aggregate demand,AD A P Y AD 2 AS 2 1. A decrease in aggregate demand causes output to fall in the short run but over time, the short-run aggregate-supply curve shifts and output returns to its natural rate. CP3P3 B P2P2 Y2Y2 Copyright © 2004 South-Western

Possible causes of Decrease of AD Consumption – Decline in wealth due to stock market crash – Pessimistic expectations as depression drags on – Credit market problems (Fisher, Bernanke) Deflation increases value of debt from 1920s Reduces the value of banks assets Increased cost of credit intermediation

Gold Standard Problems Begins in period Gold Standard functions like a pegged exchange rate system For this system to work, countries must let their money supply change with gold flows – If exports>imports, gold flows in, Ms↑, P ↑ – If imports>exports, gold flows out, Ms ↓, P↓ Britain is dominate country, willing to do this WWI all countries go off gold standars

WWI ends Britain is no longer dominant economy, US is unwilling to be the leader European countries are indebted to US, to pay loans must export more than they import, means US, Ms ↑, P ↑ but US will not do this Problems with the exchange rates when countries go back on the gold standard – Old rates do not reflect new reality – New countries which did not exits before – General chaos

Recovery Economy hit its trough in March 1933, month FDR took office New Deal – National Industrial Recovery Act (NIRA )passed June 1933 – Agricultural Adjustment Act (AAA) – Both were designed to increase prices by allowing firms to collude and paying farmers not to produce

Other new deal programs – Works Progress Administration (WPA) created temporary jobs New Deal spending is large by standards of the time, but no consensus in the literature that it had a large effect Roosevelt was not a Keynesian, felt the problem was with the structure of the economy.

1933 US goes off the gold standard, begins to increase money supply Friedman and Schwartz identify this as crucial change

Why is recovery so slow? Ohanian and Cole, JPE, August 2004 Go back to NIRA – Allowed business to collude to raise prices without any prosecution from antitrust as long as workers had a collective bargaining agreement – Allowed workers to demand 25% increase in wages

Unemployment Unemployment goes down, but official rate is still high in the 1940s

Adjusted rate includes temporary jobs

If wages are higher than equilibrium, unemployment will increase If prices are higher than equilibrium, surplus NIRA was declared unconstitutional in 1935 FDR found ways to get around it – Antitrust cases dropped 50% – Increase in collective bargaining Find wages and prices 25% higher than they should have been

Other New Deal Issues What explains pattern of New Deal Spending? Roosevelt stated goals were relief, recovery and reform More aid does not go to states with lowest per capita income. – South does not get as much Some evidence of political motivation

Recovery is underway by the time US enters WWII

WWII Recovery is underway by the time US enters WWII in 1941 Major changes to the Economy – Increase in government intervention (Private industry mobilized in support of war effort) – Wage and Price controls – Increase labor force participation of women Concern about economic performance after war ends in 1945.

What happens? Increase in economic growth. This is real gdp with a log scale.

Why do we see increase in growth rate after WWII? Different international institutions. – Bretton Woods conference results in instituitions to make multilateral economic cooperation easier. GATT, World Bank, IMF etc US does not attempt to collect war debts Increase in rate of technological change

Application of science to technological problems Starts during WWII Variety of different institutions involved – Government – Universities – Private firms and research labs Lots of diversity